Regulators’ Shake-Up Seen as Missed Bid to Police JPMorgan

Manuel Balce Ceneta/Associated PressThomas Curry, comptroller of the currency, who testified to Congress in June, said he was reviewing JPMorgan’s practices.

After the financial crisis, regulators vowed to overhaul supervision of the nation’s largest banks.

As part of that effort, the Federal Reserve Bank of New York in mid-2011 replaced virtually all of its roughly 40 examiners at JPMorgan Chase to bolster the team’s expertise and prevent regulators from forming cozy ties with executives, according to several current and former government officials who spoke on the condition of anonymity.

But those changes left the New York Fed’s front-line examiners without deep knowledge of JPMorgan’s operations for a brief yet critical time, said those people, who spoke on the condition of anonymity because there is a federal investigation of the bank.

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Forced to play catch-up, the examiners struggled to understand the inner workings of a powerful investment unit, those officials said. At first, the examiners sought basic information about the group, including the name of the unit’s core trading portfolio.

By the time they got up to speed, it was too late. In May, JPMorgan disclosed a multibillion-dollar trading loss in the investment unit.

They “couldn’t ask tough questions,” said a former official who was based at JPMorgan.

The situation highlights the fundamental challenge of policing big banks, even after the crisis.

As regulators added to their ranks and aimed to increase the sophistication of their teams, the transition was not always smooth. The staff turnover at the New York Fed happened over several months, and regulators made a concerted effort to retain knowledge of the bank’s activities, according to other people close to the New York Fed who were not authorized to speak publicly on the matter.

Even so, the current and former officials said the Fed examiners faced a daunting task, given that the bank has more than $2 trillion in assets.

Faced with overseeing large banks like JPMorgan, regulators cannot possibly comb through every loan document or trade. Instead, they rely primarily on a bank’s own analysis of its risk, a broad portrait that can mask problems.

“They aren’t examiners as much as they are overseers, forced to peer over the banks’ shoulders,” Bart Dzivi, who served as special counsel to the Federal Crisis Inquiry Commission, said in reference to the general state of large bank supervision.

The New York Fed’s shake-up only aggravated a continuing struggle between JPMorgan executives and regulators from the Office of the Comptroller of the Currency, which supervises banks. For years, the agency, with dozens of its own examiners at JPMorgan, worried that the bank had been miscalculating how much money it could lose in extreme situations, according to the current and former officials.

Examiners challenged the executives who stonewalled, and the conflict left agency supervisors with an incomplete picture of the bank’s risk. At one point in early 2012, JPMorgan briefly stopped providing examiners with an important risk estimate for the chief investment office, the group at the center of the recent trading losses, the current and former officials said. Executives told examiners not to worry.

For their part, regulators say it is not their job to micromanage or remove risk altogether. Their goal is to protect the financial system broadly.

In a statement, the Comptroller of the Currency, Thomas Curry, said his agency was “reviewing the risk management practices at JPMorgan Chase, following the losses announced in May.”

The review, he said, referring to the chief investment office, “includes risk management policies and controls that govern both the C.I.O. and the rest of the bank. That information will be used to determine what supervisory actions and changes are appropriate.”

The JPMorgan trading losses will receive fresh scrutiny on Friday when the bank reports its quarterly results. It is expected to report a profit and detail the extent of the losses, which have reached about $5 billion, according to people briefed on the matter.

The bank’s chief executive, Jamie Dimon, also might explain more about what went wrong. Mr. Dimon has shuffled staff, apologized before Congress and moved to unwind the complex trade related to the losses, which was tied to credit derivatives, complex financial instruments.

Both JPMorgan and the New York Fed declined to comment.

Years before the multibillion-dollar losses, the embedded staff from the Office of the Comptroller of the Currency questioned how JPMorgan was estimating its risk.

In 2008, the agency’s examiners inside JPMorgan raised broad concerns about the bank’s internal stress test models, according to the current and former officials. The examiners said that they were worried that the bank’s analysis incorrectly calculated the potential effect on various businesses from a variety of conditions, including large market swings and sudden fluctuations in interest rates.

One report, for example, estimated that the bank’s chief investment office would lose no more than $400 million in a two-week period even under the most stressful market conditions, one of the government officials said.

Some of the agency’s examiners said they had battled to get senior executives at JPMorgan to share how the bank’s internal stress tests were structured. One of the former officials described the analysis as a virtual black box, in which the bank provided few details about the variables.

JPMorgan executives resisted providing any additional information about the stress tests, including how they chose the variables used to forecast potential losses. The bank routinely pushed back scheduled meetings to review the matter, the current and former officials said.

“We were most concerned with the fact that the stress test is one of the most important risk management reports,” said one of the former bank examiners, and the test’s methodology “had not been reviewed by regulators.”

Compounding their frustrations, Joseph Bonocore, the bank’s treasurer, left in October 2011. In the ensuing months, some of the examiners said they had less access to information about the bank.

That same year, the New York Fed was retooling its team at JPMorgan. The Fed saw an opportunity to rethink the way it policed the industry. It hired a new head of bank supervision, added staff with greater financial expertise and revamped the roster of examiners stationed at the banks.

But the transition came at a critical time for JPMorgan. In 2011, the once little-known chief investment office was swelling in size and taking on increasingly risky bets.

By early 2012, the Office of the Comptroller of the Currency conducted a review of JPMorgan’s stress test models, months before reports emerged about potential losses in the chief investment office, according to the current and former officials. The examination revealed that the models needed upgrades.

At one point in the first quarter of this year, some of the examiners said that JPMorgan had simply stopped providing them with some metrics from the chief investment office. When they asked why the crucial value-at-risk measure had disappeared, executives did not give them a satisfying answer.

Around that time, the bank changed the value-at-risk measure for the chief investment office, which they did not disclose publicly for months. The switch would prove important.

By changing the metric, the bank could seemingly take on more risk. It all came to a head in May when the bank announced a $2 billion trading loss on a soured credit bet.

Since then, losses have multiplied to an expected $5 billion in the second quarter, a tally that could grow.